Reading the Signs

The Dow is over 22,000. The S&P 500 is making new records. So’s the Russell 2000—a widely followed small stock index. Everyone is excited about the market making new highs. Well, not everyone: doomsayers and perma-bears aren’t thrilled. They thought the Fed’s stimulus of our post-Financial Crisis economy created a “sugar high,” and when they took the stimulus away, the markets would fall back to earth.

Well, that didn’t happen. The economy has strengthened, even in the face of collapsing oil prices and a retail apocalypse. The latest employment report seems to reinforce these trends. A virtuous cycle is developing, where higher employment leads to higher incomes which strengthens the economy leading to higher employment.

Only, are some parts of the market flashing a warning light?

Over the past three years – since oil prices collapsed in 2014 – the market has been dominated by growth stocks, and especially by the big five tech companies: Amazon, Facebook, Google, Microsoft, and Apple. In fact, they’ve been responsible for over a quarter of the market’s advance since then. And their dominance seems to be increasing. This could spell trouble. A narrow market is not a healthy market. It’s vulnerable to shocks and surprises that hit the market’s leaders.

One way to measure how narrow a market has become is to contrast the movement of a capitalization-weighted index, like the S&P 500, with a similar equal-weighted index. Most indices are weighted by the size of the companies in them. Microsoft, whose outstanding shares are worth $560 billion, counts more towards the cap-weighted index than does Ralph Lauren, the clothes designer, worth $6 billion. When you have a bull market, you want everyone to participate. And everyone in this market has, to a certain extent. Except the big five have participated more than the rest. As a result, the equal-weighted index has lagged behind the cap-weighted index by almost 5% over the last three years. That has some folks worried. It reminds them of the late-‘90s tech bubble.

Recent S&P 500 vs. S&P 500 Equal-Weight. Source: Bloomberg.

But these comparisons don’t carry a lot of weight. The market’s divergence in the late ‘90s was breathtaking. People really thought we were on the verge of a new era. Tech stocks really diverged from the rest of the market. Folks thought Warren Buffett, who confessed that he didn’t understand technology, was out of it. In the three year run-up to the market’s top, the S&P 500 diverged from the equal-weighted index by over 50%. And while the cap-weighted index was making new highs, the equal-weighted index was trending down, with lower highs and lower lows.

Late ‘90s S&P 500 vs. S&P 500 Equal-Weight. Source: Bloomberg.

Folks comparing this market to the late ‘90s need to get out more. Yes, we have a narrow market. And yes, hindsight is 20-20 (if you bother to look). But this is nothing compared to back then.

To re-phrase a saying used in a different – 1990s – context: I’ve seen the ‘90s; I invested in the ‘90s; the ‘90s were good decade to learn from. Mr. Market, this is no 1990s divergence.

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Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. -
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